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Challenging Albert Edwards: have profits peaked?

With the earning season finished, one of the hardest issues for asset allocators to decide upon is whether corporate profits have peaked, especially in the UK and the US.

By the end of last week, more than 90% of S&P 500 companies had reported, with the results generally better than expected for another quarter. 

The continuous profits-busting performance of US large caps since March 2009 was best summed up by last week’s Fortune 500 List, which revealed the total profits of the 500 companies that make up the index ‘increased by 81% – $318 billion – the third largest percentage gain in the list’s history’.

Likewise, with Friday’s announcement that non-farm payrolls had increased by 244,000, outpacing the economists’ forecast of 186,000 job increases, it would be almost natural to assume the economic recovery is back on track and companies remain confident of continued profits, hence the hiring.

Analyst mood

But Albert Edwards, the Société Générale strategist known as something of a perma-bear, argues that profits may have peaked. The thrust of his argument, in terms of the market, is that there has been a change in analyst optimism.

Edwards says this is at the core of what drives equity prices and in a note to clients explained that a change in US analyst optimism quickly picks up swings in actual optimism.

But in a typically downbeat note on equities, he said: ‘The level of analyst optimism also seems to be turning down (albeit from high levels).’

Edwards adds that although US stock market profits are supposedly booming, a number of indicators, such as pre-tax domestic non-financial profits and core durable goods orders, have ‘stalled’.

He says: ‘Despite the Chicago Fed National Activity Index (CFNI) suggesting that some near-term economic strength is “baked in the cake”, some other key cyclical indicators seem to be rolling over.

‘Durable goods orders posted a better-than-expected 2.9% rise in March as did “core” orders – excluding the volatile defence and aircraft components. Yet despite March’s strength, both the year-on-year and six-month change in core orders has slowed sharply in recent months.’

In light of this slowdown, Edwards warned that investors need to start re-evaluating the case for equities. He says: ‘With valuation unattractive and now earnings per share momentum slowing (even before QE2 ends), this is the point in the cycle when investors should be becoming more cautious.’

Grim UK outlook

Indeed, in the UK there is definitely reason to think corporate profits are not going to go higher, according to Tim Price (pictured), director of investments at PFP Wealth Management.

 

‘It’s a plausible thesis that earnings have peaked,’ he said. ‘I would certainly be anticipating in the UK a second drop down to recessionary conditions.’

Price cites the austerity measures, which are yet to be felt by the populace, as a key deterrent to a continuation of buoyant profits. He also points out that the VAT hike and low confidence are other key factors that need to be taken into consideration.

‘From a UK point, all I see is headwinds to come. It’s quite likely that we have seen the high in a lot of sectors, particularly the cyclical sector,’ he added.

Indeed, Mike Lenhoff, chief strategist at Brewin Dolphin, has mapped the relative performance of cyclical versus defensive stocks in the UK, showing that the rotation away from cyclical towards defensives has been under way for many months.

He said: ‘[The data is based on] the UK but is likely to be typical of what is happening in other developed equity markets.’

Meanwhile, Jim Wood-Smith, head of research at Williams de Broë, says determining whether corporate profits have peaked is incredibly hard at the moment. ‘Certainly, the weight of growth of profits is starting to slow down but that’s a mathematical certainty as we have come out of a recession and profit growth has been quick.’

Wood-Smith (pictured) says the rate of growth in profits will inevitably slow down sharply, but he also notes there is relatively robust global profits growth.

 

Margins a key questions

However, he points to the more complicated question of profit margins as an important consideration when asking whether corporate profits have peaked.

‘Global profit margins are at record levels and there is a school of thought which says that [because of] commodities costs, and the inability of companies to pass on higher costs or being able to offset these through productivity gains, we are at a peak of a very long margin cycle,’ he said.

‘If you are at a peak of a very long margin cycle then global return on equity is going to come down, which means equity ratings are not cheap.’

David Miller, head of alternatives at Cheviot, agrees with Wood-Smith and says margins are at a high level, which means investors ‘have to be a bit suspicious of companies’ ability to build or grow margins from this level’.

 

Miller points out that many companies have enjoyed satisfactory conditions to build their margins as they have been able to grow profits because of cost-cutting and efficiency improvements.

Likewise, he says, because of high unemployment companies have been able to keep wages low. But now the question becomes focused on whether these margins are sustainable.

He said: ‘Our view is that they are sustainable for the moment [especially] companies with pricing power which have operational gearing or those that are good businesses. Although profitability is good, we don’t think it will start coming down sharply.’

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